Taking a Pragmatic Approach to Smart Contracts

Momentum appears to be building for the adoption of smart contracts. Smart contracts offer compelling benefits – from streamlining to automation of the contracting process – and they have the potential to, amongst other capabilities, improve efficiency, reduce client costs and legal risk. But just how should the legal industry respond?

Like with any new technology, a pragmatic approach must be adopted and current limitations must be taken into account. As Matthew Williams, Consultant and Akber Datoo, Managing Partner at D2 Legal Technology insist, any lawyers looking to adopt smart contracts need to understand where they can be applied and where they would deliver most value to clients. This means rapidly adapting the skills mix – from recruiting computer and data scientists with legal understanding to upskilling lawyers with foundational technology and data skills, ensuring they are equipped with the knowledge and confidence to help clients unlock business value through legal change and in this case, smart contracts.

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According to research organisation Gartner, by 2022, smart contracts will be in use by more than 25% of global organisations. Yet while this might sound like a ringing endorsement for this nascent legal technology, look beyond the headline and such assertions are carefully tempered with multiple caveats. Notably, this level of adoption applies only to ratified unbundled smart contracts – namely those that are both closely defined and with narrow impact. This does not apply to the real contracting world, with complex nested contracts that can be affected by multiple outcomes, which start to reach the limits of what is possible to test as a smart contract using formal methods.

Essentially, right now, commentators believe that just a highly simplified interpretation of the smart contract concept may gain adoption; representing a tiny fraction of overall commercial contracts negotiated. The 25% figure quoted by Gartner is open to interpretation and could be considered somewhat misleading: smart contract adoption en-masse will take much longer and require significant advances in technology, both security and volume processes, but more fundamentally understanding and culture to bring them into the mainstream.

There is no doubt that the concept of smart contracts has significant appeal. For commentators such as Richard Susskind who believe that automation could spell the end of lawyers, smart contracts very much fit that message. However, while clients may be getting excited about the opportunities to reduce complexity – and cost – and reduce the need for trusted third parties, are they willing to rely on two complementary, albeit distinct technologies in blockchain and smart contracts, that are still yet to be fully realised and their legal validity tested, let alone confirmed?

Practical considerations

Right now, the hype is far ahead of the practical adoption of smart contracts, for several reasons. For a start, there is no agreed definition of the term – with academics and experts still lacking consensus, over twenty years since the concept was first conceived by Nick Szabo as a ‘set of promises, specified in digital form, including protocols within which the parties perform on these promises.’

It is this combination of automated process and human input, however, that underpins the ongoing challenges regarding the adoption and enforcement of smart contracts. A whitepaper jointly published by the trade association ISDA and magic circle law firm Linklaters explored the continuum that exists in the form of a smart contract which is entirely in code and a smart contract combining natural language and code. It is still uncertain as to where on this spectrum successful smart contracts will lie. The answer will in part depend on whether there will be this development of lawyers with the confidence in the technology and the ability to undertake, or at least be involved in the review of the code, possibly in some more amenable form, representing the smart contract. Additionally, they would need to be able to understand where to optimally blend code with the natural language required for non-operational contracts.

Furthermore, there are concerns regarding DLT; from the inherent reliance upon cryptocurrencies, with their dark web connotations and global concerns regarding their future stability, to the open and public nature of DLT networks. The financial market is looking to address this with the creation of closed, market-specific DLTs – and it is possible the legal profession will follow suit. Indeed, some law firms may decide the only secure option is to develop their own bespoke DLTs, but DLTs are impractically slow right now. By way of example, the Bitcoin Blockchain can only process five to seven transactions per second and the Ethereum Blockchain can process around just over twenty. Public Blockchain networks are also incredibly expensive to run, requiring a significant amount of computational power. Iceland’s energy consumption is expected to double due to the effect of blockchain mining, which may limit its practical commercial usage. The processes, skills and business practices relating to the wholesale adoption of smart contracts are still very much under development.

Immature model

Clearly the automation and self-execution enabled by smart contracts is hugely compelling, offering the legal profession a chance to streamline processes and reduce overheads. A proportion of contracts could be automated, at least in part. Event-driven contracts, such as AXA’s Fizzy flight insurance smart contract has, to date, been a good example of a smart contract that could be executed via a DLT without difficulty. But the vast majority of contracts will require a combination of coded smart contract and natural language to support non-operational clauses. Firms need to develop strategies for storing these contracts – from determining how they are split across a DLT and the existing Document Management solution to ensuring ease of retrieval and review.

Furthermore, while a contract may be drawn up in one country, the smart contract code could be stored anywhere on the DLT globally; should a contract be questioned, under which governing law would a case be tried? The potential for a contract to face years of legal wrangling simply to agree jurisdiction cannot be overlooked – with many firms considering the creation of a pre-contract smart contract to a defined jurisdiction. With these considerations in mind, the judiciary is starting to take note of the legal implications of smart contracts with Sir Geoffrey Vos, Chancellor of the High Court, recently calling for a test case to provide some clarity as to legal status of smart contracts.

This is most definitely still a work in progress. Developments are exciting, as smart contract companies such as Clause.io are looking to feed real-time Internet of Things (IoT) data into a smart contract and use real-time data – such as from a delivery van to support supply chain processes, to the creation of standardised pieces of code to provide further automation – and minimise lawyers’ coding requirements. However, before any such innovation can be embraced, the fundamentals must be in place: lawyers will still require a basic understanding of systems, data and IT development before being let loose in the use of any standardised code if they are to avoid unintentionally including bugs or errors within the contract. (A secondary question of course being the professional expectations of a lawyer in respect of such activities, and where any liability might lie in cases where it goes wrong!). The concept of plug and play smart contracts is currently unrealistic.

Practical Next Steps

Smart contracts clearly have the potential to be a key technology for the future once it has matured and legal considerations are resolved. Until then, the legal profession must take practical next steps to fully unlock the business value of smart contracts. As well as addressing the educational and skill set gap, there needs to be greater appreciation of business processes related to legal agreement data and basic data governance principles put in place and implemented in relation to them. Smart contracts are data-driven to achieve a business outcome, and therefore smart contracts will fail to unlock any real business value, rather “rubbish in, rubbish out”.

With these practical steps in mind, it is essential to step back and understand the true implications of this technology. It is tantalising and logically compelling and without doubt will have a significant role to play in the years ahead. But there is a long way to go before businesses can confidently and wholeheartedly embrace smart contracts for anything other than the simplest of agreements. To gain real traction, DLTs need to mature, smartcontracts need to be legally tested, and they need to be enforceable. The future is now, the future is legal and DLT.